As a business owner, you know how crucial it is to accurately track your financial activities. Monthly cash flow, accounts payable and accounts receivable, net profits—you need all this financial data to gauge performance and make wise budgeting decisions.
Financial statements give you a high-level view of your company’s financial position and results of operations to help you make those decisions. Understanding your company’s financial condition means that you can identify relevant business opportunities while also avoiding costly mistakes.
What is a financial statement?
Financial statements help investors, managers, and business owners better understand the financial stability and profit potential of a company.
They can also have other uses, like helping business owners and stakeholders:
- Determine a company’s ability to generate cash and identify cash sources
- Examine and predict potential profitability challenges
- Track financial results
- Determine a company’s ability to pay back debts
- Track a company’s financial performance
With the proper accounting software solution, you can spot opportunities and improve your company’s strategic standing in both the short term and long term.
Let’s take a closer look at the financial statements your company may need and the best way to record all of this essential information.
What are the three main financial statements a business needs?
When you’re a relatively young small business, figuring out what kinds of documents and reports you need to keep track of the money coming in and going out can be challenging
But no matter the size, there are three primary financial statement documents that you or your accounting team need to accurately record, track, and analyze your business’s financial health for month-end or any timely reporting. These key financial documents are balance sheets, income statements, and cash flow statements.
#1: Balance sheet
A balance sheet provides information about a company’s assets, liabilities, and the owner’s or shareholders’ equity at a specific point in time.
Balance sheets are necessary because they provide a look into a company’s current book value. It shows what a business owns and owes.
Balance sheet calculations are about finding the book value of a company’s assets, which is different from its market value.
The balance sheet equation is:
Need a breakdown? Assets are anything a company owns. Liabilities are any amount of money a company owes to a creditor. The owner’s equity is the company’s net worth, the amount of money left over if all assets were sold and all liabilities were paid.
However, balance sheets alone don’t reveal information on past trends or predictions, so it’s helpful to use them in tandem with other financial statements.
#2: Income statement
An income statement (also called a profit and loss statement or P&L) focuses on a company’s income and expenses during a specified accounting period.
The company’s income statement shows financial trends in business activities. When an income statement shows multiple periods, it lets you compare revenues, expenses, and profits from different periods, which is important for understanding financial performance.
Ultimately, the income statement shows whether the company is profitable and measures how much money it spends to produce its products or services.
Total net income is determined by subtracting the total expenses and losses from the total revenue and gains:
Need a breakdown? Revenue is the amount of money a business makes. Gains are considered “other income.” They indicate net money from other activities, like selling fixed assets. Total expenses is the total amount of money spent on running the business. Losses are other expenses that aren’t a part of normal operations, like taking a loss on equipment disposal.
#3: Cash flow statement
Cash flow statements provide a more detailed picture of the business’s cash inflow and outflow during a specified accounting period. Measuring the inflow of cash helps shareholders, investors, other business leaders, and employees understand how the company operates in the short term or long term.
It’s important to understand that cash flow is not the same as a company’s profit. Cash flow is the money that comes in and goes out of a company, while profits refer to what’s left after you deduct all expenses.
For the company’s cash flow formula, you have to add or subtract all the cash from operating activities, investing activities, and financing activities. Then add the result to the beginning cash balance:
The result should agree to your ending cash balance for the period.
As you can see, cash flow is broken down into three sections: operating, investing, and financing activities. If you need a breakdown, here’s the difference between the three:
- Operating activities are cash flows used for daily business operations, including cash received from sales, cash paid for expenses, and receivables collected.
- Investing activities refer to the cash spent on business investments, like purchasing or selling assets, including physical property (like real estate or vehicles) and intangible property (like patents or bond certificates).
- Financing activities are the cash flows from debt and equity financing, like business loans and capital contributions.
Two common methods for using financial statements
The most common way to use financial statements is to use the information in the financial statements to calculate ratios. In business and finance, ratios allow business leaders to observe and understand the relationships between items and benchmark their performance against the competition or industry averages.
For example, if you want to compare your business to a competitor’s, the right ratio will help you better understand your profitability and performance so you can remain one step ahead.
Here are two of the most common ratios used for financial statements.
Inventory turnover ratio
The inventory turnover ratio measures the rate at which inventory is sold, used, and replaced. It helps leaders understand how well their company manages its inventory and balances supply versus demand.
While high turnover isn’t desirable when talking about your employees, in this case, higher turnover rates are actually a good thing. High inventory turnover means products are selling quickly, and there’s less need to store inventory, allowing room for new products.
Calculate the inventory turnover ratio by dividing the cost of goods sold (COGS) by the average inventory for a specific accounting period:
The inventory turnover ratio is a well-known and well-used formula because it’s one of the easiest ways to measure a company’s efficiency. This ratio helps businesses better manage inventory so there’s not too much overhead or too little supply.
However, without deeper analysis, focusing on the inventory turnover ratio puts business leaders at risk of accidentally brushing over slow-moving items. This is because the ratio only measures the average figures.
Operating margin
Operating profit margin (also called the return on sales, or RoS) is a profitability ratio that measures a company’s overall financial health by determining how much profit it makes after paying operating and non-operating expenses.
For example, the operating margin in a manufacturing facility could measure the profit after paying for production costs, like raw materials or direct labor.
Before you use the formula, first calculate the operating income by subtracting COGS from revenue. With the operating income in hand, you’ll use this formula to find the operating margin:
Say that a company has a revenue of $1,000,000, COGs sold of $50,000, and administrative expenses of $400,000. Its operating income would be $450,000.
Now, divide the operating income of $450,000 by the original revenue of $1,000,000, which equates to .45, or 45%. The higher the operating margin, the more money a company makes. So 45% is an excellent margin (although admittedly a rare one since anything above 15% is considered great!).
A better understanding of your company’s financial position
Measuring your company’s financial health through financial statement analysis is critical to determining both current and future business activities—but you need a tool that can bring all your financial data together in one place.
BILL’s integrated financial operations platform lets you manage accounts payable, accounts receivable, spending, and expenses on one platform and syncs seamlessly with your accounting software. Schedule a demo today to learn more.
